Understanding your personal finances is the first step in taking control of your money and making it work harder for you.
One valuable tool for determining your financial status involves using personal finance ratios. These are akin to formulas that show the relationship between numbers and how your cash is tracking.
For instance, you might look at how your debt is versus your income or how your budget categories are stacking against versus your take-home pay. Calculating and considering these figures can help you manage your money better as well as achieve your short- and long-term goals.
To help you put these important ratios to use, this guide shares eight formulas to help you optimize your money.
Emergency Fund Ratio
An emergency fund is the cash you keep on hand to pay for unexpected expenses, such as a job loss, a large medical bill, or a roof repair.
This fund acts as a safety net so you don’t have to go into debt or raid your long-term savings accounts to take care of the situation.
Formula: Monthly Expenses X 6 = Emergency Fund Ratio
To calculate your target emergency fund, you’ll want to add up your essential monthly expenses, or the minimum amount of money you need to live for one month. That includes your mortgage or rent, insurance, utilities, and groceries.
One common rule of thumb is to then multiply this by three months (as a bare minimum); while others may aim for six months. This gives you a good number to shoot for keeping in your emergency fund.
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Liquid Net Worth Ratio
This formula is essentially an extension of your emergency fund. If you were to need funds as a result of an unplanned event or emergency, this metric looks at how many months of expenses would be covered by your liquid assets — funds that can be easily and quickly converted into cash.
Formula: Liquid Assets/Monthly Expenses = Liquidity Ratio
Liquid assets include your checking and savings accounts, as well as cash-like equivalents. For this number, you do not want to include other assets that are not liquid, such as your home, car, or tax-advantaged retirement savings accounts.
Monthly expenses include essential expenses that you accounted for above to determine your emergency fund ratio.
A common goal: maintaining a liquidity ratio of between three and six months.
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Personal Cash Flow Ratio
Cash flow is a term often associated with companies. But this can also be a simple yet powerful personal finance ratio because it tells you how much is flowing in vs. flowing out of your accounts each month.
Knowing how much cash flow you have is useful because it tells you exactly how much money you have available to pay down debt or save or invest for your future.
Formula: Monthly (After Tax) Income – Monthly Expenses = Personal Cash Flow Ratio
To calculate this, you’ll want to add up all of your average monthly take-home income, including your paycheck, any side hustles, and income from any investments or savings accounts that are available to you for spending.
Next, you can look at credit card and bank statements, as well as receipts, for the past several months to come up with the average amount you are spending each month. This includes necessities like mortgage or rent and utilities, and also discretionary spending such as eating out and entertainment.
You can then subtract your spending number from your income number and you’ll have your net cash flow. If that number isn’t where you want it to be, you can use these calculations as a starting point to make adjustments.
Generally, the higher your cash flow, the better off you are.
Housing-to-Income Ratio
This ratio is vital to helping you understand how much you can afford to spend on your home, whether you buy or rent. It is also an important metric that mortgage lenders use when they decide whether or not to approve your loan.
Formula: Monthly Housing Costs/Gross Monthly Income = Housing Ratio
It’s important to use total housing costs when you calculate this ratio. This includes: your monthly mortgage payments (or rent payments), property taxes, insurance, and utilities.
You can then compare that total cost to your gross monthly income (income before taxes are deducted). Financial experts often recommend keeping this number to 28% or less. In some high cost-of-living areas, closer to 40% can be common.
The lower this number, the more affordable your housing costs are and the more income you have for other financial goals.
Debt-to-Income Ratio
The debt-to-income ratio is often used to determine a company’s ability to pay its debts. It works for individuals as well. It tells you what percentage of your income is being used to repay debts.
Formula: Monthly Debt Payments/Monthly Gross Income = Debt-to-Income Ratio
To calculate your debt payments, you’ll want to include credit card, student loan, and other consumer debt, as well as your mortgage payments. Your gross income is how much you earn each month before any deductions or taxes are taken out.
The common wisdom is to keep your debt at or below 36% of your gross income, but the lower your debt-to-income ratio, the financially healthier you likely will be.
Many people are surprised when they calculate this number to find just how much of their income is going to repay debt, often at high interest rates. This ratio can help you rethink that situation.
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Net Worth Ratio
Personal net worth is a measurement of an individuals’ total wealth. Your net worth ratio gives a little bit broader perspective than your debt-to-income ratio because it takes your total assets into account.
It is calculated as the total value of all your assets minus the total value of all your liabilities.
Formula: Total assets – Total Liabilities = Net Worth Ratio
To find this ratio, you’ll want to add up the current market values of all of your assets including your home, stock and bond holdings, checking and savings accounts, and any other financial accounts.
Next you’ll want to calculate your total liabilities. This includes any debt such as mortgages, credit card balances, car loans, personal loans and 401(k) loans.
You can then subtract your liabilities from your assets. The resulting number is, hopefully, positive, and the higher that positive number, the better for your financial health.
This is a snapshot of your net worth at this moment. You may want to calculate this metric periodically, perhaps quarterly or annually, to track your wealth. Ideally, you should see increases over time.
Savings Ratio
Since saving for the future is such a key part of personal finances, it makes sense there would be a personal finance ratio to help you gauge how you’re doing.
Your savings rate is expressed as what percent of your gross income you are putting away for the future, including retirement and other shorter-term financial goals.
Formula: Savings/Gross Income = Savings Ratio
To calculate this, you’ll want to add up your annual savings in any retirement accounts, including employer-sponsored retirement plans such as 401(k)s, traditional and Roth IRAs and taxable accounts earmarked for retirement. Do not include your emergency fund or college savings accounts.
Compare that savings to your annual gross income (your earnings before taxes and deductions are taken out).
Generally speaking, you want to aim for a saving rate of 10% to 20%. Younger people may want to aim for a 10 percent savings ratio, and then gradually increase their savings rate as their income increases.
50/30/20 Budget Ratio
The 50/30/20 formula can help you manage your budget no matter what your income. It proves a simple guideline as to how to apportion your income so you can afford to pay your bills, have some fun, and also put money into savings.
Formula: 50% Essential Spending + 30% Discretionary Spending + 20% Savings = Budget Ratio
Essential needs are the largest allocation at 50% of monthly take-home income. These are bills you must pay including mortgage or rent, utilities, health insurance, and groceries. Housing will likely take up a big chunk of this category.
With this formula, you’ll want to keep discretionary spending at no more than 30% of your monthly take-home income. These are most likely the things you do for fun, like dining out, travel, clothing beyond what you need for work, and entertainment.
Saving for future financial goals accounts for the remaining 20% of monthly take-home income. This includes retirement savings, saving for a house, tuition savings, saving to repay debt, etc.
The Takeaway
Personal finance ratios can give you a clear snapshot of your financial health in a variety of areas and help you make better decisions about money management and future planning.
Rather than making a best guess, personal financial ratios give you an edge in your analysis by using simple math. Once you’ve done some of these calculations, you may discover that you want to make some changes, such as watching your spending more closely and/or putting more money into savings each month.
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